Thursday, March 26, 2009

Real Capitalists Nationalize

Sorry, zombie banks. The laws of the market dictate that we should own your ass.

by Kevin Drum

Mother Jones (March 15 2009)

The titans of Wall Street may not have done a bang-up job of running the American financial sector over the past few years, but would a bunch of politicians in Washington, DC, do any better? We're probably about to find out - and to understand how we got here, and why it suddenly doesn't seem like such a bad idea, you've got to start at the beginning. The very beginning.

In America, it's the stock market that gets all the headlines. If you're sentient enough to fog a mirror, you know that stocks have dropped by half in the past eighteen months. It's been a disaster for 401(k)s and pension funds across the country.

But the fact is that this is a sideshow.

The total size of the US equities market - the value of every single share of stock traded on US exchanges - is about $10 trillion. The size of the US credit market is more than $30 trillion. What's more, credit is more important than equities. As the saying goes, credit is like oxygen: You don't realize how much you need it until it's gone. When credit dries up - as it has recently - the economy grinds to a halt.

But why has credit dried up? Let's back up again. The main providers of credit are banks, and the amount of money they can lend depends on two things: their capital stock and their capital ratios. Say that you and some friends decide to start a bank and you pitch in $1 billion to get things rolling. That's your capital. And say that your bank makes a profit of $1 billion for nine years in a row. Your capital is now $10 billion.

The amount you can loan out depends on your capital ratio, a number that's set in the US by the Securities and Exchange Commission. If you're required to have, say, a five percent capital reserve, that means your loan portfolio can be as high as twenty times your capital. That's $200 billion - and if you fudge things a bit, say through the creative use of off-balance-sheet vehicles, maybe you can loan out as much as $300 billion. If the average return on your loan portfolio is five percent, that means you're making about $15 billion per year with only $10 billion of your own money at stake. Not bad.

But then a crash comes. Homeowners start defaulting on their loans, and you have to write off the losses. That cuts into your capital; plus, with the economy falling, it's prudent to reduce your leverage. Instead of thirty to one, maybe you'll cut back to twenty to one. The end result is that you're lending way less money than you used to.

This is, roughly, what's been happening to the global financial system. Loan losses have reduced capital. Everyone is hoarding money. It's called deleveraging, and in plain English it means that credit markets are broken.

But things can still get worse. What happens if your capital is wiped out completely by loan losses? Then your bank is insolvent. The lights are still on, people still come to work, and bills still get paid, but there's no lending at all. And without lending, you aren't really a bank. You're a zombie.

So is the American banking system insolvent? It's probably pretty close. But this doesn't mean that every bank is insolvent. It just means that the overall average is neutral: Some banks are doing fine, while others are deeply in the hole. And the ones who are in the hole, which include some of the country's biggest, need to be dealt with. But how?

We could, of course, simply let the bad banks fail. But that's what the government allowed to happen to Lehman Brothers last September, and the results were catastrophic. Markets went wild, credit froze, and there was a run on money market funds that stopped only when the Fed stepped in to guarantee them. When a really big bank fails - and some of the banks currently in trouble are a lot bigger than Lehman - it can cause a cascade of defaults that ignites a global firestorm and destroys entire economies. So no matter how appealing it sounds on poetic-justice grounds to let the banks that got us into this mess simply go under, the infuriating fact is that we simply can't afford to let that happen.

Aside from allowing banks to fail, then, there are four main options. The first is to muddle through. The US banking system is still profitable, after all, and this means that over time insolvent banks will build their capital base back up and start lending again. Unfortunately, "over time" could mean years, and nobody wants a broken banking system for that long. (Japan tried this after its banking crisis of the early 1990s, and the result is popularly known as the "Lost Decade".)

Option Number Two is for the government to set up what's called a "bad bank" that buys up the banking system's "toxic waste", loans that have gone bad and are likely to get even worse, eating up bank capital along the way. Unfortunately, the reason this stuff is called "toxic" is because the eventual losses from these loans are impossible to forecast. Are they worth seventy cents on the dollar? Fifty cents? Twenty cents? Nobody knows, and without knowing that, it's impossible to buy them up. There's still a plan on the books to attempt the purchase of toxic assets, but most observers give it little chance of success unless it's so heavily subsidized by the government that it amounts to little more than a massive giveaway.

That leads us to Option Number Three: recapitalization. Last year, after former Treasury Secretary Henry Paulson realized that buying up toxic waste wouldn't work, he decided to provide direct capital infusions to banks. The idea here is simple: If the banks don't have enough capital, then give them some more. Even with big losses, if you give them enough, then they'll be able to lend money once again.

One problem, though: There's no reason for taxpayers to simply give money to banks. We need to get something in return. But what?

Paulson's answer was preferred stock, a weird hybrid entity that counts as equity but is really just a thinly disguised loan. There's nothing inherently wrong with that, except that Paulson bought the shares on giveaway terms. Take Goldman Sachs, for example, which received $5 billion in new capital from Warren Buffett last September. In return Buffett received a dividend yield of ten percent per year and, according to an analysis by Bloomberg, warrants worth $3.6 billion.

And Paulson? He gave Goldman $10 billion a month later, and in return received a dividend of five percent for the first five years and warrants worth less than $1 billion. Eight other big banks got similar terms at the same time. It was a sweetheart deal deliberately designed to not put additional stress on the banks, but the flip side is that taxpayers got robbed. Simon Johnson, a former research director for the International Monetary Fund, said at the time that the transactions were "just egregious". Paulson seemed to be spending more time figuring out how to spend taxpayer dollars in ways that wouldn't offend the delicate sensibilities of the folks getting the checks than he was in getting a good deal for the taxpayers.

But the reason for those easy terms isn't hard to figure out. Basically, if Paulson had paid any more, he would have owned several of the banks he gave money to. Take Citigroup. So far they've received two capital injections from the government worth a total of $45 billion. But that's more than the entire bank is worth. As I write this, Citigroup stock is trading for less than $2; you could buy up the entire bank for less than $10 billion. But Paulson didn't want to own Citi, and the only way to make sure he didn't was to give it money on such absurdly favorable terms that $45 billion only bought a small share of the company. That's good news for Citi and the other banks that got easy money from the government, but both politicians and the public have gotten tired of such handouts.

So, finally, this brings us to Option Number Four: temporary nationalization. Here, the big problem is, since the banks haven't exactly been honest about their books, how do you decide which ones are insolvent and which can keep going on their own? Assessing the capital position of a big bank with a complex balance sheet is a notoriously tricky task, as much art as science, and shareholders and creditors have a legitimate beef if the government takes over a bank and wipes out their investment when the bank might still be solvent and able to grow out of its problems on its own. John Hempton, a former bank executive and Australian treasury official, suggests a solution he calls "nationalization after due process": A third party is hired to comb the bank's books, and if they're found to be undercapitalized they're given a chance to raise the needed capital privately from investors. If investors aren't willing to pony up even knowing the bank's position, then it's nationalized, and shareholders can't complain that they weren't given a fair chance to save their investment.

This specific idea might or might not work, but certainly some kind of consistent, transparent system is needed to make the process fair and acceptable. Sweden, for example, which went through a housing bubble followed by a banking crisis in the early 1990s, created a Bank Support Authority that forced banks to fairly account for their losses without the smoke and mirrors common to internal accounting. Two were eventually taken over.

President Obama clearly has considered the Swedish experience: "They took over the banks", he said on Nightline last month, "nationalized them, got rid of the bad assets, resold the banks, and a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model." Yet, he went on, the United States has a "different set of cultures" than Sweden, and Americans would find nationalization a hard pill to swallow.

Unsaid but implicit in Obama's statement, though, is that Americans could likely be persuaded to accept nationalization if they understand that all the alternatives are worse. In fact, this may have been exactly the point of the bank rescue plan Obama's treasury secretary, Timothy Geithner, announced shortly after that interview. A key element of the plan involves a mandatory "stress test" for the country's biggest banks, which sounds remarkably similar to Hempton's third-party auditor and Sweden's Bank Support Authority. It could turn out to have been a smart PR move as much as anything: Get everyone talking about the stress tests, worrying about the stress tests, gossiping about the stress tests - and by the time the results become public, it's hard to imagine any recourse other than nationalization for the banks that don't pass.

The stress test is also a way to address both of the two big problems with nationalization. Not only can it fairly decide which banks are solvent and which ones aren't, but it also addresses the dreaded "contagion" problem: Since investors are wiped out when a bank is nationalized, the mere fear of nationalization can scare private investors away from every bank, even the good ones. But if stress tests are done on every bank and the bad ones are all nationalized at once, the good banks are freed from fears that they might be next on the government chopping block.

And in truth, nationalization is more than the least worst option: It actually has a lot of benefits. It allows rapid reorganization and write-down of debts without the associated chaos of a bank failure. It wipes out shareholders and forces creditors to take a haircut, just as in a normal bankruptcy. And unlike endless capital injections in return for small stakes, it's a fair option for American taxpayers, who deserve to own more than just a minority share if they're investing more than the bank is worth in the first place.

Nationalization also solves the problem of valuing toxic assets: The government can simply sit on the stuff until the market turns up and then sell it off for the best price it can get. There's no need to immediately value it at all. Most important, with the full faith and credit of the United States government behind them, nationalized banks can be recapitalized and made into functional credit providers again. And as soon as they're back on their feet, they can be sold back to the private sector, as happened in Sweden. Taxpayers will still lose a lot of money on the deal - there's really no way of avoiding that at this point - but nationalization keeps those losses lower than any of the alternatives.

And there's one more thing about nationalization to keep in mind: We already do it all the time. The FDIC now takes over small banks every week, and among bigger institutions the government has already effectively nationalized Fannie Mae, Freddie Mac, and insurance giant AIG. And for the most part, life goes on as usual. If Citigroup or Bank of America were taken over, the board of directors would be dissolved, some of the senior staff would be replaced, shareholders and bondholders would take a hit, and the bank would continue running as normal except with a stronger capital base and government guarantees behind it. Then, in a few years, it would be refloated and put back in private hands. It's not as scary as it sounds.

As finance blogger Steve Waldman has put it, "real capitalists nationalize". The fundamental principle of a free market system is that ownership and control of failed enterprises should reside in the hands of whoever buys up the corpse. If that's the government, then that means nationalization. This may be why temporary nationalization has won the support not just of mainstream economists like Nouriel Roubini and Paul Krugman, but of no less a free market acolyte than former Fed chairman Alan Greenspan. "It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring", he told the Financial Times in February. "I understand that once in a hundred years this is what you do".